CHAPTER 1

ENVIRONMENT AND THEORETICAL STRUCTURE OF FINANCIAL ACCOUNTING

Overview
The primary function of financial accounting is to provide useful financial information to users external to the business enterprise. The focus of financial accounting is on the information needs of investors and creditors. These users make critical resource allocation decisions that affect the nations economy. The primary means of conveying financial information to investors, creditors, and other external users is through financial statements and related notes. In this chapter you explore important topics such as the FAS s conceptual frame!ork that serve as a foundation for a more detailed study of financial statements, the !ay the elements of these statements are measured, and the concepts underlying these measurements and related disclosures.

Learning Objec ive!

"#$%$ &escribe the function and primary focus of financial accounting. "#$%' (xplain the difference bet!een cash and accrual accounting. "#$%) &efine generally accepted accounting principles *+AA,- and discuss the historical development of accounting standards, including convergence bet!een ..S. and international standards. "#$%/ (xplain !hy the establishment of accounting standards is characteri0ed as a political process. "#$%1 (xplain factors that encourage high23uality financial reporting. "#$%4 (xplain the purpose of the conceptual frame!ork. "#$%5 Identify the ob6ective and 3ualitative characteristics of financial reporting information, and the elements of financial statements. "#$%7 &escribe the four basic assumptions underlying +AA,. "#$%8 &escribe the recognition, measurement and disclosure concepts that guide accounting practice. "#$%$9 :ontrast a revenue;expense approach and an asset;liability approach to accounting standard setting. "#$%$$ &iscuss the primary differences bet!een ..S. +AA, and IF<S !ith respect to the development of accounting standards and the conceptual frame!ork underlying accounting standards.

Lec "re O" #ine Par A$ Financia# Acc%"n ing Envir%n&en

I' T(e F"nc i%n an) Pri&ar* P"r+%!e %, Financia# Acc%"n ing A. There are a number of financial information supplier groups as !ell as several external user groups. *T$2$. The primary focus of financial accounting is on the information needs of investors and creditors. :. Financial statements convey financial information to external users. *T$2'$. alance sheet or statement of financial position '. Income statement or statement of operations
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). Statement of cash flo!s /. Statement of shareholders= e3uity 1. Starting in '9$', either a- a statement of other comprehensive income immediately follo!ing the income statement, or b- a statement of comprehensive income *including information on the income statement as !ell as on the statement of other comprehensive income-. II' T(e Ec%n%&ic Envir%n&en an) Financia# Re+%r ing A. The capital markets provide a mechanism to help our economy allocate resources efficiently. . :orporations, the dominant form of business organi0ation in the .nited States in terms of the o!nership of productive resources, ac3uire capital from investors in exchange for o!nership interest and by borro!ing from creditors. :. The investment2credit decision>A cash flo! perspective $. A company !ill be able to provide a return to investors and creditors only if it can generate cash receipts from selling a product or service that exceed the cash disbursements necessary to provide that product or service. '. The ob6ective of financial accounting is to provide information to investors and creditors to help them predict future cash flo!s. &. :ash versus accrual accounting $. #ver short periods of time, operating cash flo! may not be an accurate predictor of future operating cash flo!s. '. The accrual accounting model provides a measure of periodic performance called net income. ). ?et income is considered a better indicator of future operating cash flo!s than is current net operating cash flo!s. *T$2)III' T(e Deve#%+&en %, Financia# Acc%"n ing an) Re+%r ing S an)ar)! A. @istorical perspective and ..S. standards *T$2/$. +enerally accepted accounting principles *+AA,- are a set of guidelines companies follo! in measuring and reporting financial information. '. The Securities and (xchange :ommission *S(:- has the authority to set accounting standards for companies, but al!ays has delegated the task to the accounting profession. ). The Financial Accounting Standards oard *FAS - currently sets accounting standards. /. The FAS Accounting Standards :odification became effective on Auly $, '998, and no! represents the single source of authoritative nongovernmental ..S. +AA,, except for rules and interpretive release of the S(:, !hich remain also as sources of authoritative +AA,. 1. The :odification is organi0ed into nine main topics and approximately 89 subtopics. *T$21. International standard setting $. The International Accounting Standards :ommittee *IAS:- !as formed in $85) to develop global accounting standards. The IAS: reorgani0ed itself and created a ne! standard2setting body called the International Accounting Standards oard *IAS -.
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'. The IAS: acts as an umbrella organi0ation similar to the Financial Accounting Foundation in the .nited States. The International Accounting Standards oard *IAS - has responsibility for developing international financial reporting standards *IF<Ss-. ). The organi0ations involved in setting IF<Ss parallel those involved in setting ..S. +AA,. *T$24'. IAS standards are used in some form in over $$1 6urisdictions, including the companies in the (uropean .nion. :. :onvergence bet!een FAS and IAS standards $. In '99' the FAS and IAS signed the ?or!alk Agreement, pledging to remove existing differences bet!een standards. Since then, both boards have been !orking to!ards convergence. '. In ?ovember '997, the S(: proposed a <oadmap for the potential use of financial statements prepared in accordance !ith IF<S. The <oadmap sets forth several milestones that, if achieved, could lead to the re3uired use of IF<S by publicly2traded ..S. companies. ). ,rogress has been slo! achieving milestones, and the S(: has postponed making a decision on !hether the ..S. !ill incorporate IF<S into ..S. +AA,, and if so, !hen that event !ill occur. The S(: has guaranteed that it !ill not occur before '9$1. /. #ne possible process by !hich incorporation could occur !as described by the S(: as BcondorsementC, !hich involves continuing the convergence process coupled !ith endorsement of additional International Financial <eporting Standards by the FAS for inclusion in ..S. +AA, if those standards are of sufficiently high 3uality. .nder this approach, the S(: and FAS still have sovereignty over ..S. accounting standards, but those standards should largely converge to IF<S over time. &. The establishment of accounting standards>A political process $. A standard setter must consider potential economic conse3uences of accounting standards. '. The FAS undertakes a series of information gathering steps before issuing a substantive accounting standard. *T$25). In the past, various interest groups have successfully lobbied standard setters for changes in standards involving such topics as accounting for stock2based compensation, business combinations, and other2than2temporary impairments of investments. /. ,olitical pressures on IAS standard setting are severe, !ith funding dependent on voluntary contributions and important groups like the (. threatening to Bcarve outC aspects of standards that they vie! as undesirable. IV' Enc%"raging (ig(-."a#i * ,inancia# re+%r ing A. Auditors offer credibility to financial statements by verifying that they are presented fairly in conformity !ith +AA,. . The %u&lic Compan' !ccountin" Re(orm an In)estor %rotection !ct o( 2002, commonly referred to as the *ar&anes-+,le' !ct, provides for the regulation of auditors and the types of services they furnish to clients, increases accountability if corporate executives, addresses conflicts of interest for securities analysts, and provides for stiff criminal penalties for violators. *T$27:. <ecent accounting scandals have rekindled the debate over principles-&ase , or more recently termed, o&-ecti)es-oriente , versus rules-&ase accounting standards. A
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principles2based approach to standard setting stresses professional 6udgment, as opposed to follo!ing a list of rules. IV' E (ic! in Acc%"n ing A. <ecent accounting scandals have rekindled the debate over principles-&ase , or more recently termed, o&-ecti)es-oriente , versus rules-&ase accounting standards. A principles2based approach to standard setting stresses professional 6udgment, as opposed to follo!ing a list of rules. . (thical 6udgment is critical in accounting, particularly if decisions are not specified by rules. $. (thics deal !ith the ability to distinguish right from !rong. '. Dany professions have articulated ethical standards in a code of ethics. ). There are a number of steps that provide a frame!ork for analy0ing ethical issues. *T$28-

Par /$ T(e C%nce+ "a# Fra&ew%r0

I' P"r+%!e %, (e C%nce+ "a# Fra&ew%r0 A. The conceptual frame!ork does not prescribe +AA,. . It provides an underlying foundation for accounting standards. :. The FAS and IAS are !orking together to develop a common and improved conceptual frame!ork. The pro6ect consists of eight phases and only ,hase A has been completed. &. The frame!ork consists of a financial reporting ob6ective, 3ualitative characteristics of information, financial statement elements, recognition and measurement concepts, and constraints. *T$2$9-

II' Objec ive %, Financia# Re+%r ing *T$2$9A. To provide financial information that is useful to capital providers. III' F"n)a&en a# 1"a#i a ive C(arac eri! ic! %, Acc%"n ing In,%r&a i%n *T$2$$A. #verriding ob6ective is decision usefulness. . ,rimary 3ualities of useful information are relevance and faithful representation. :. :omponents of relevance areE $. ,redictive value '. :onfirmatory value ). Dateriality is an aspect of information that enhances relevance &. :omponents of faithful representation areE $. :ompleteness '. ?eutrality ). Free from error (. (nhancing 3ualities are comparability *including consistency-, verifiability, timeliness and understandability. F. A key constraints is cost effectiveness. IV' E#e&en ! %, Financia# S a e&en ! *T$2$'A. alance sheet elementsE $. Assets '. "iabilities ). (3uity /. Investments by o!ners
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1. &istributions to o!ners . Income statement elementsE $. <evenues '. +ains ). (xpenses /. "osses 1. :omprehensive income V' Un)er#*ing A!!"&+ i%n! *T$2$)A. (conomic entity assumption . +oing concern assumption :. ,eriodicity assumption &. Donetary unit assumption VI' Rec%gni i%n2 Mea!"re&en an) Di!c#%!"re C%nce+ ! A. <ecognition $. An item should be recogni0ed in the basic financial statements !hen it meets certain criteria. *T$2$/'. <evenue recognition typically depends on reali0ation, !hich re3uires that the earnings process be virtually complete and there is reasonable certainty as to the collectivility of assets to be received. ). (xpense recognition typically matches expenses to the periods in !hich they are incurred to produce revenue. . Deasurement *T$2$1$. +AA, uses a Bmixed attributeC model, in !hich different attributes are used to measure different financial statement elements. '. The five measurement attributes commonly employed in +AA, areE a. @istorical cost b. ?et reali0able value c. :urrent cost d. ,resent value e. Fair value $- The FAS has provided a frame!ork for measuring fair value !henever fair value is called for in applying +AA,. *T$2$4'- +AA, gives a company the option to report some or all of its (inancial assets and liabilities at fair value. :. &isclosure *T$2$5$. Financial reports should include any information that could affect users decisions. '. Techni3ues for providing full disclosure include parenthetical comments, disclosure notes and supplemental schedules and tables. VII' Ev%#" i%n %, Acc%"n ing Princi+#e! A. T!o competing approaches for the recognition of revenues and expense are *$- the revenue;expense approach and *'- the asset;liability approach. . .nder the revenue;expense approach, principles for recogni0ing revenues and expenses are emphasi0ed, !ith assets and liabilities recogni0ed as necessary to make the balance sheet reconcile !ith the income.
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:.

.nder the asset;liability approach, principles for asset and liability measurement are emphasi0ed, and revenues, expenses, gains and losses are recogni0ed as necessary to make the balance sheet reconcile !ith the income statement.

P%werP%in S#i)e! A ,o!er,oint presentation of the chapter is available at the textbook !ebsite.

Teac(ing Tran!+arenc* Ma! er! The follo!ing can be reproduced on transparency film as they appear here, or you can use the disk version of this manual and first modify them to suit your particular needs or preferences.
FINANCIAL INFORMATION SUPPLIER GROUPS AND E3TERNAL USER GROUPS

PROVIDERS OF
FINANCIAL INFORMATION

E3TERNAL USER
GROUPS

,rofit2oriented companies

Investors :reditors *banks, bondholders, other lenders(mployees "abor unions :ustomers

?ot2for2profit entities *e.g., government entities, charitable organi0ations, schools-

Suppliers

+overnment regulatory agencies *e.g., Internal <evenue Service, Securities and (xchange :ommission The McGraw-Hill Companies, Inc. 2013 1-0 Interme iate !ccountin", #$e

@ouseholds

Financial intermediaries *e.g., financial analysts, stockbrokers, mutual fund managers, credit rating organi0ations-

Illustration $2$

T$2$

FINANCIAL STATEMENTS

The primary means of conveying financial information to investors, creditors, and other external users is through financial statements and related notes. The financial statements most fre3uently provided areE $. '. ). /. 1. abThe balance sheet or statement of financial position The income statement or statement of operations The statement of cash flo!s The statement of shareholders= e3uity Starting in '9$', either a statement of other comprehensive income immediately follo!ing the income statement, or a statement of comprehensive income *including information on the income statement as !ell as on the statement of other comprehensive income-.

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T$2'

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CASH VERSUS ACCRUAL ACCOUNTING :arter :ompany > ) Fears of #perating Transactions
4ear 1 Sales *on creditNe O+era ing Ca!( F#%w!$ :ash receipts from customers :ash disbursements ,repayment of three years= rent Salaries to employees .tilities Ne %+era ing ca!( ,#%w *49,999*19,999*1,999G*41,999292 *19,999*$1,999G 49,999 292 *19,999*$9,999G 41,999 *49,999*$19,999*)9,999G 49,999
Illustration $2'

4ear 5 G$99,999

4ear 6 G$99,999

T% a# G)99,999

G$99,999

G 19,999

G$'1,999

G$'1,999

G)99,999

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Deasuring the same activities by the accrual accounting model provides a more accurate prediction of future operating cash flo!s. :arter :ompany > Income Statements
4ear 1 4ear 5 G$99,999 '9,999 19,999 $9,999 79,999 G '9,999 4ear 6 T% a#

<evenues (xpensesE <ent Salaries .tilities Total expenses ?et Income

G$99,999 '9,999 19,999 $9,999 79,999 G '9,999

G$99,999 G)99,999 '9,999 19,999 $9,999 79,999 49,999 $19,999 )9,999 '/9,999

G '9,999 G 49,999
Illustration $2)

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ACCOUNTING STANDARD SETTING

HIERARCH4 OF STANDARD-SETTING AUTHORIT4 :ongress S(: ,rivate Sector

7
:A, A, FAS
Illustration $2/

T$2/
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FAS/ Acc%"n ing S an)ar)! C%)i,ica i%n T%+ic!

T%+ic +eneral ,rinciples ,resentation Assets "iabilities (3uity <evenues (xpenses road Transactions Industry N"&bere) $992$88 '992'88 )992)88 /992/88 1992188 4992488 5992588 7992788 8992888

Illustration $21

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THE FAS/8! STANDARD-SETTING PROCESS

..S. +AA, Securities (xchange :ommission *S(:IF<S International #rgani0ation of Securities :ommissions *I#S:#-H International Accounting Standards :ommittee Foundation *IAS:F-E '' trustees International Accounting Standards oard *IAS -E $/ members *$' full2timeI ' part2 time-

<egulatory oversight provided byE

Foundation providing Financial Accounting oversight, appointing Foundation *FAF-E '9 members, raising trustees fundsE Standard2setting boardE Financial Accounting Standards oard *FAS -E 5 full2time members

Advisory council providing input on agenda and pro6ectsE +roup to deal !ith emerging issuesE

Financial Accounting Standards Advisory :ouncil Standards Advisory *SA:-E )92/9 members :ouncil *FASA:-E )92/9 members (merging Issues Task Force *(ITF-E $1 members International Financial <eporting Interpretations :ommittee *IF<I:-E $/ members

H(ach countrys security regulator has authority. I#S:# includes representatives from numerous regulators, including the S(:, to facilitate coordination among those regulators and other organi0ations and encourage effective capital markets.
Illustration $24

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THE FAS/8! STANDARD-SETTING PROCESS

STEP $. E3PLANATION The oard receives re3uests;recommendations for possible pro6ects and reconsideration of existing standards from various sources. The FAS :hairman decides !hether to add a pro6ect to the technical agenda, sub6ect to oversight by the Foundation=s oard of Trustees and after appropriate consultation !ith FAS Dembers and others. The oard deliberates at one or more public meetings the various issues identified and analy0ed by the staff. The oard issues an (xposure &raft. *In some pro6ects, a &iscussion ,aper may be issued to obtain input at an early stage that is used to develop an (xposure &raft.The oard holds a public roundtable meeting on the (xposure &raft, if necessary. The staff analy0es comment letters, public roundtable discussion, and any other information. The oard redeliberates the proposed provisions at public meetings. The oard issues an Accounting Standards .pdate describing amendments to the Accounting Standards :odification.
Illustration $25

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). /.

1. 4.

5.

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T@( SA< A?(S2#J"(F A:T

9e* Pr%vi!i%n! %, (e Ac $
Over!ig( b%ar)' The five2member *t!o accountants- ,ublic :ompany Accounting #versight oard has the authority to establish standards dealing !ith auditing, 3uality control, ethics, independence and other activities relating to the preparation of audit reports, or can choose to delegate these responsibilities to the AI:,A. ,rior to the act, the AI:,A set auditing standards. The S(: has oversight and enforcement authority. C%r+%ra e e:ec" ive acc%"n abi#i *' :orporate executives must personally certify the financial statements and company disclosures !ith severe financial penalties and the possibility of imprisonment for fraudulent misstatement. ?%n-a")i !ervice!. The la! makes it unla!ful for the auditors of public companies to perform a variety of non2audit services for audit clients. ,rohibited services include bookkeeping, internal audit outsourcing, appraisal or valuation services, and various other consulting services. #ther non2audit services, including tax services, re3uire pre2approval by the audit committee of the company being audited. Re en i%n %, w%r0+a+er!' Auditors of public companies must retain all audit or revie! !ork papers for seven years or face the threat of a prison term for !illful violations. A")i %r r% a i%n' "ead audit partners are re3uired to rotate every five years. Dandatory rotation of audit firms came under consideration. C%n,#ic ! %, in ere! ' Audit firms are not allo!ed to audit public companies !hose chief executives !orked for the audit firm and participated in that companys audit during the preceding year. Hiring %, a")i %r' Audit firms are hired by the audit committee of the board of directors of the company, not by company management. In erna# C%n r%#' Section /9/ of the Act re3uires that company management document and assess the effectiveness of all internal control processes that could affect financial reporting. The ,:A# s !u itin" *tan ar 3o. 2 *since replaced by !u itin" *tan ar 3o. /- re3uires that the company auditors express an opinion on !hether the company has maintained effective internal control over financial reporting. Illustration $21

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ANAL4TICAL MODEL FOR ETHICAL DECISIONS S e+ 1' S e+ 5' &etermine the facts of the situation. This involves determining the !ho, !hat, !here, !hen, and ho!. Identify the ethical issue and the stakeholders. Stakeholders may include shareholders, creditors, management, employees, and the community. Identify the values related to the situation. For example, in some situations confidentiality may be an important value that may conflict !ith the right to kno!. Specify the alternative courses of action. (valuate the courses of action specified in step / in terms of their consistency !ith the values identified in step ). This step may or may not lead to a suggested course of action. Identify the conse3uences of each possible course of action. If step 1 does not provide a course of action, assess the conse3uences of each possible course of action for all of the stakeholders involved. Dake your decision and take any indicated action.

S e+' 6

S e+ ;' S e+ <'

S e+ ='

S e+ >'

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THE CONCEPTUAL FRAME?OR9

Objec ive To provide financial information that is useful to capital providers. P(a!e A 1"a#i a ive C(arac eri! ic! Pri&ar* Re#evance ,redictive value :onfirmatory value Dateriality Fai (,"# Re+re!en a i%n :ompleteness ?eutrality Free from error En(ancing C%&+arabi#i * *including consistencyVeri,iabi#i * Ti&e#ine!! Un)er! an)abi#i * P(a!e A Rec%gni i%n an) Mea!"re&en C%nce+ !

E#e&en ! Assets "iabilities (3uity Investments by o!ners &istributions to o!ners <evenues (xpenses +ains "osses :omprehensive income

A!!"&+ i%n! (conomic entity +oing concern ,eriodicity Donetary unit Princi+#e! <evenue recognition (xpense recognition Dixed attribute measurement Full disclosure SFAC =

Financia# S a e&en ! K alance sheet K Income statement K Statement of cash flo!s K Statement of shareholders= e3uity K Statement of :omprehensive Income K <elated disclosures

SFAC < SFAC >

C%n! rain :ost effectiveness P(a!e A

Illustration $28

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1UALITATIVE CHARACTERISTICS OF ACCOUNTING INFORMATION PRIMAR4 1UALITATIVE CHARACTERISTICS Re#evance

Pre)ic ive va#"e C%n,ir&a %r* va#"e En(ancing a!+ec $ &a eria#i * C%&+#e ene!! > All information that is necessary for faithful representation. Ne" ra#i * > Accounting standards should be set !ith overall societal goals and specific ob6ectives in mind, and should try not to favor particular groups or companies. Free ,r%& err%r

Fai (,"# re+re!en a i%n

ENHANCING 1UALITATIVE CHARACTERISTICS C%&+arabi#i * Ability to help users see similarities and differences among events
and conditions *also includes consistenc' -.

Veri,iabi#i * :onsensus among different measurers. Ti&e#ine!! Available to users before a decision is made. Un)er! an)abi#i * .sers must understand the information.

CONSTRAINT$ COST EFFECTIVENESS

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ELEMENTS OF FINANCIAL STATEMENTS

A!!e ! Liabi#i ie! ,robable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. ,robable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. :alled shareholders e3uity or stockholders e3uity for a corporation is the residual interest in the assets of an entity that remains after deducting its liabilities. Increases in e3uity of a particular business enterprise resulting from transfers to it from other entities of something of value to obtain or increase o!nership interests in it. &ecreases in e3uity of a particular enterprise resulting from transfers to o!ners. The change in e3uity of a business enterprise during a period from transactions and other events and circumstances from nono!ner sources. It includes all changes in e3uity during a period except those resulting from investments by o!ners and distributions to o!ners. Inflo!s or other enhancements of assets of an entity or settlements of its liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entitys ongoing ma6or or central operations. #utflo!s or other using up of assets or incurrences of liabilities during a period from delivering or producing goods, rendering services, or other activities that constitute the entitys ongoing ma6or, or central, operations. Increases in e3uity from peripheral or incidental transactions of an entity. <epresent decreases in e3uity arising from peripheral or incidental transactions of an entity.

E."i * @%r ne a!!e !A Inve! &en ! b* %wner! Di! rib" i%n! % %wner! C%&+re(en!ive inc%&e

Reven"e!

E:+en!e!

Gain! L%!!e!

Illustration $2$$

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UNDERL4ING ASSUMPTIONS
L Ec%n%&ic En i * A!!"&+ i%n
All economic events can be identified !ith a particular economic entity.

L G%ing C%ncern A!!"&+ i%n

In the absence of information to the contrary, it is anticipated that a business entity !ill continue to operate indefinitely.

L Peri%)ici * A!!"&+ i%n

The life of a company can be divided into artificial time periods to provide timely information to external users.

L D%ne ar* Uni A!!"&+ i%n

Financial statement elements should be measured in terms of the .nited States dollar.

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RECOGNITION
Rec%gni i%n B An i e& !(%"#) be rec%gniCe) in (e ba!ic ,inancia# ! a e&en ! w(en i &ee ! (e ,%##%wing cri eria$ &efinition > the item meets the definition of an element of financial statements. Deasurability > the item has a relevant attribute measurable !ith sufficient reliability. <elevance > the information about it is capable of making a difference in user decisions. <eliability > the information is representationally faithful, verifiable, and neutral *,hase A of the 6oint FAS ;IAS conceptual frame!ork pro6ect has replaced reliability !ith faithful representation as the second primary 3ualitative characteristic of financial information-. Rea#iCa i%n Princi+#e <evenue should be recogni0ed only after the earnings process is virtually complete and there is reasonable certainty of collecting the asset. <evenue should be recogni0ed in the period it is earned, not necessaril' in the perio in which cash is recei)e . Ma c(ing Princi+#e (xpenses are recogni0ed in the same period as the related revenues. T$2$/

MEASUREMENT
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Mea!"re&en B A!!%cia ing n"&erica# a&%"n ! % (e e#e&en !' +AA, uses a Bmixed attributeC model Deasurement attributes presently used to measure different financial statement elements includeE historical cost net reali0able value current cost present value of future cash flo!s fair value

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FAIR VALUE HIERARCH4

"evel Inputs (xample

$ M%! De!irab#e

Muoted market prices in active markets for identical assets or liabilities.

In :hapter $' you !ill learn that certain investments in marketable securities are reported at their (air )alues. Fair value in this case !ould be measured using the 3uoted market price from the ?FS(, ?AS&AM, or other exchange on !hich the security is traded. In :hapter $9 !e discuss ho! companies sometimes ac3uire assets !ith consideration other than cash. In any noncash transaction, the controlling valuation principle is that each element of the transaction is recorded at its (air )alue. If one of the assets in the exchange is a building, for instance, then 3uoted market prices for similar buildings recently sold could be used to value the building or, if there !ere no similar buildings recently exchanged from !hich to obtain a comparable market price, valuation could be based on the price per s3uare foot derived from observable market data. Asset retirement obligations *A<#s-, discussed in :hapter $9, are measured at (air )alue. ?either level $ nor level ' inputs !ould be possible in most A<# valuation situations. Fair value !ould be estimated using level ) inputs to include the expected cash flo!s estimated using the entitys o!n data if there is no information that indicates that market participants !ould use different assumptions. This level ) input !ould be used in a present value calculation together !ith other inputs such as the credit2ad6usted risk free interest rate.

'

Inputs other than 3uoted prices that are o&ser)a&le for the asset or liability. These inputs include 3uoted prices for similar assets or liabilities in active or inactive markets and inputs that are derived principally from or corroborated by observable related market data.

) Lea! De!irab#e

4no&ser)a&le inputs that reflect the entitys o!n assumptions about the assumptions market participants !ould use in pricing the asset or liability developed based on the best information available in the circumstances.

Illustration $2$)

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FULL-DISCLOSURE PRINCIPLE
L The ,"##-)i!c#%!"re +rinci+#e means that the financial reports
should include any information that could affect the decisions made by external users, sub6ect to the cost effectiveness constraint. Supplemental information is disclosed in a variety of !ays, including +aren (e ica# or &%)i,*ing c%&&en ! placed on the face of the financial statements. Di!c#%!"re n% e! conveying additional insights about company operations, accounting principles, contractual agreements, and pending litigation. S"++#e&en a# ,inancia# ! a e&en ! that report more detailed information than is sho!n in the primary financial statements.

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S"gge! i%n! ,%r C#a!! Ac ivi ie! 1' Rea# ?%r#) Scenari%

America #nline *A#"- is a leader in the Internet access provider industry. In $884, the company changed a controversial accounting method involving the treatment of the cost of advertising and free trials. The follo!ing is an excerpt from a Day $1, '999, C35T 3ews.com articleE America #nline !ill pay a civil penalty of G).1 million as part of a settlement !ith the Securities and (xchange :ommission over the accounting of advertising costs. According to the S(:, the Internet and media giant improperly reported most of the costs of ac3uiring ne! subscribers % such as the expense of sending computer disks to potential customers % as an asset. As a result, the S(: said A#" posted a profit for six of eight 3uarters in $881 and $884 but !ould have recorded a loss if the company follo!ed recommended accounting practices. A#", backed by its auditor, defended the accounting method of capitali0ing these costs arguing that spreading the costs over t!o years !as a 6ustifiable !ay to match expenses against revenue flo!s that !ould emerge later. In $884, A#" s!itched to expensing these costs in the period incurred. S"gge! i%n!$ @ave the class consider the general treatment of advertising and promotion costs. Nhy are these costs normally expensed in the period incurred even though they are incurred !ith the intention of generating future revenuesO Nhy did they expense these costs over a t!o2year periodO Then discuss the possible reasons !hy A#" chose a different approach follo!ed by a discussion of the possible reasons !hy the company decided to change its method. Another interesting discussion is the civil penalty of G).1 million leveled by the S(: four years after A#" changed its method. This could lead to a general discussion of the S(:s role in the financial reporting process. P%in ! % n% e$ ,erhaps an important factor prompting the s!itch !as the increased competition in the industry and the loss of customers that prompted A#" to implement a ne! pricing scheme. The loss of customers creates significant uncertainty !ith respect to the reali0ation of deferred advertising and promotion costs. Another reason is pressure exerted by the S(: to make the s!itch and another is that A#"s competitors all expensed these costs.

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5'

De## Ana#*!i!

@ave students, individually or in groups, go to the most recent &ell Inc. annual report using (&+A< !hich can be located atE ww'!ec'g%v. Ask them toE $. :ompare revenues, total costs and expenses, net income, total assets and total shareholders= e3uity !ith those in the '9$$ report in Appendix of the text. Are there any discernible trendsO @o! might they be interpretedO '. .se (&+A< to locate the most recent annual report information for Apple, &ells competitor. .sing the most recent annual report information for both companies, compareE a. gro!th rates in revenues and net income, and b. the relationship bet!een revenues and net income *profit margin-.

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6'

Gr%"+DRe!earc( Ac ivi *

The debate over principles2based versus rules2based accounting standards provides an excellent opportunity for class discussion, in2class debate, or for a !riting assignment. #ne suggestion is to form groups of / or 1 students to research the issue. Assign half of the groups to defend a principles2 based approach and the other half to defend the rules2based approach. There are numerous articles !ritten on the sub6ect. A google search !ill find many hits. For example a link to a C%! 6ournal article entitled B&efining ,rinciples2 ased Accounting StandardsC appears belo!. httpE;;!!!.nysscpa.org;cpa6ournal;'99/;79/;essentials;p)/.htm Also, the Darch '991 issue of !ccountin" Hori7ons contains a commentary entitled B<ules2 ased Standards and the "ack of ,rinciples in Accounting.C

;'

In erna i%na# Acc%"n ing Ac ivi *

Nhat are the advantages and disadvantages to accounting convergenceO T!o recent articles in Accounting @ori0ons provide an excellent overvie! of the research evidenceE "u0i @ail, :hristian "eu0, and ,eter Nysocki *'9$9- +lobal Accounting :onvergence and the ,otential Adoption of IF<S by the ..S. *,art I-E :onceptual .nderpinnings and (conomic Analysis. !ccountin" Hori7onsE September '9$9, Pol. '/, ?o. ), pp. )112)8/. "u0i @ail, :hristian "eu0, and ,eter Nysocki *'9$9- +lobal Accounting :onvergence and the ,otential Adoption of IF<S by the ..S. *,art II-E ,olitical Factors and Futre Scenarios for ..S. Accounting Standards. !ccountin" Hori7onsE &ecmber '9$9, Pol. '/, ?o. /, pp. 1452 177. S"gge! i%n!$ @ave your students !rite a paper summari0ing the issue and the papers results. Alternatively, have a debate in !hich different groups of students take pro2 vs. con2convergence positions.

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Pr%,e!!i%na# S0i##! Deve#%+&en Ac ivi ie!

The follo!ing are suggested assignments from the end2of2chapter material that !ill help your students develop their communication, research, analysis and 6udgment skills.

C%&&"nica i%n S0i##!' In addition to :ommunication adapted to ask students to !rite a letter to the client. :ase $2$ do !ell as group assignments. (thics :ase create good class discussions. Audgment :ases $2$$, presentation*s-.

:ase $25, Audgment :ase $2$' can be :ommunication :ase $24 and Audgment $27 and Audgment :ases $28 and $2$9 $2$) and $2$4 are suitable for student

Re!earc( S0i##!' In their careers, our graduates !ill be re3uired to locate and extract relevant information from available resource material to determine the correct accounting practice, perhaps identifying the appropriate authoritative literature to support a decision. <esearch :ases $2', $2), and $2/ and (xercises $2) and $2/ provide excellent opportunities to help students develop this skill by introducing them to some important resources available on the Internet.
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Ana#*!i! S0i##!' The B roaden Four ,erspectiveC section includes Analysis :ases that direct students to gather, assemble, organi0e, process, or interpret data to provide options for making business and investment decisions. In addition to Analysis :ase $2$), rief (xercise $2$, (xercises $2$ and $2', and <eal Norld :ase $2$1 also provide opportunities to develop and sharpen analytical skills. E")g&en S0i##!' The B roaden Four ,erspectiveC section includes Audgment :ases that re3uire students to critically analy0e issues to apply concepts learned to business situations in order to evaluate options for decision2making and provide an appropriate conclusion. This chapter includes Audgment :ases $2$, $28, $2$9, $2$$, $2$', and $2$/. The AirFrance2Q"D cases 3uestion ) re3uires consideration of potential departures from IF<S.

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='

E (ica# Di#e&&a
The chapter contains the follo!ing ethical dilemmaE

ETHICAL DILEMMA
Fou have recently been employed by a large retail chain that sells sporting goods. #ne of your tasks is to help prepare periodic financial statements for external distribution. The chain=s largest creditor, ?ational Savings R "oan, re3uires 3uarterly financial statements, and you are currently !orking on the statements for the three2month period ending Aune )9, '9$). &uring the months of Day and Aune, the company spent G$,'99,999 on a large radio and TP advertising campaign. The G$,'99,999 included the costs of producing the commercials as !ell as the radio and TP time purchased to run the commercials. All of the costs !ere charged to advertising expense. The companys chief financial officer *:F#- has asked you to prepare a Aune )9 ad6usting entry to remove the costs from advertising expense and to set up an asset called prepai a )ertisin" that !ill be expensed in Auly. The :F# explained that BThis advertising campaign has produced significant sales in Day and Aune and I think it !ill continue to bring in customers through the month of Auly. y recording the ad costs as an asset, !e can match the cost of the advertising !ith the additional Auly sales. esides, if !e expense the advertising in Day and Aune, !e !ill sho! an operating loss on our income statement for the 3uarter. The bank re3uires that !e continue to sho! 3uarterly profits in order to maintain our loan in good standing.C Fou may !ish to discuss this in class. If so, discussion should include these elements. S e+ 1BT(e Fac !$ #ne of your tasks as an employee of a large sporting goods chain is to prepare financial statements for external use. Fou are currently preparing 3uarterly statements for the 3uarter ending Aune )9, '9$), that !ill be given to the chain=s largest creditor, ?ational Savings R "oan. The :F# has asked you to capitali0e *charge to a prepaid asset- the G$,'99,99 cost for an advertising campaign conducted in Day and Aune of '9$). The capitali0ation of advertising !ill prevent an operating loss for the 3uarter and maintain the company=s good standing !ith the creditor. The :F# believes that the commercials improved sales in Day and Aune and expects the advertising effect to continue in Auly. The matching principle states that expenses are recogni0ed in the same period as the related revenue. In some situations it is impossible to determine in !hich periods revenues !ill be earned from expenses such as advertising. ecause of the difficulty in estimating the effect of advertising expenditures, accounting principles dictate that advertising should be recogni0ed as an expense in the period incurred. S e+ 5BT(e E (ica# I!!"e an) (e S a0e(%#)er!$ The ethical issue or dilemma is !hether your obligation to challenge the :F#=s re3uest for capitali0ation of the advertising expense is stronger than your obligation to your employer=s financial interests.

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Stakeholders include you, the accountant, the :F#, other corporate managers, company employees, the bank and other creditors, and current and future investors. S e+ 6BVa#"e!$ Palues include competence, honesty, integrity, ob6ectivity, loyalty to your employer, and responsibility to users of financial statements. S e+ ;BA# erna ive!$ $. Follo! the suggestion of the :F# to record the advertising costs as a prepaid asset. '. <ecord the advertising costs as an expense in the 3uarter ending Aune )9, '9$). ). <eport the :F#=s re3uest to a higher level of management, the audit committee, or the auditors. /. <esign from the company and seek employment else!here. S e+ <BEva#"a i%n %, A# erna ive! in Ter&! %, Va#"e!$ $. Alternative $ illustrates loyalty to the employer. '. Alternative ' exhibits the values of competence, honesty, integrity, ob6ectivity, and responsibility to users of the financial statements. ). Alternative ) illustrates loyalty to the employer at a level higher than that of the :F#, but also includes the values of honesty, integrity, and ob6ectivity on the part of the accountant. /. Alternative / supports the values of honesty and integrity, but does not reflect competence or responsibility to financial statement users. S e+ =BC%n!e."ence!$ !lternati)e 1 ,ositive conse3uencesE Fou !ould keep your 6ob and please the :F#. The company !ould remain in good standing !ith the bank. ?egative conse3uencesE .sers of the financial statements !ould be misinformed. .sers of financial statements may sue the company upon learning the truth if the amount of advertising is material and affects their financial decisions. Fou may lose your self2respect and the respect of co2 !orkers. !lternati)e 2 ,ositive conse3uencesE .sers of financial statements !ould receive more conservative information concerning advertising costs. Fou !ould maintain your integrity. ?egative conse3uencesE Fou may incur disfavor !ith the :F# and other top management, resulting in a loss of future promotions or your 6ob. Fou also may lose the trust of other employees. !lternati)e 3 ,ositive conse3uencesE Fou !ould maintain your integrity. .sers may receive more conservative information concerning advertising costs if upper management levels or the audit committee compel fair presentation in the financial statements. ?egative conse3uencesE Fou may incur disfavor !ith the :F# and other top management, resulting in a loss of future promotions or your 6ob. Fou also may lose the trust of other employees. Nhistle blo!ers often are not re!arded. !lternati)e .
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,ositive conse3uencesE Fou maintain your integrity and avoid conflict !ith management and other employees. ?egative conse3uencesE Fou have no 6ob and you may have difficulty getting references for a ne! 6ob. .sers of financial statements still do not receive correct information regarding advertising costs. S e+ >BDeci!i%n$ Student*s- must decide their course of action.

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A!!ign&en C(ar
Acce!! % (e FAS/ c%)i,ica i%n i! re."ire) ,%r an* e:erci!e! #i0e 1-6 an) 1-;' FAS/ c%n r%#! acce!! % (e c%)i,ica i%n2 b" (e* (ave an aca)e&ic +r%gra& (a )e+ar &en ! can !ign "+ ,%r' I, *%"r !c(%%# (a! +ai) ,%r a !i e #icen!e %, (e Aca)e&ic Acc%"n ing Acce!! Pr%gra&2 ,ac"# * an) ! ")en ! wi## (ave ,ree acce!! % (e FAS/ C%)i,i ca i%n' C(ec0 wi ( *%"r acc%"n ing )e+ar &en % )e er&ine i, *%"r !c(%%# (a! regi! ere) ,%r (i! +r%gra&' A## %, (e ,ea "re! avai#ab#e wi ( (e Pr%,e!!i%na# View ver!i%n @ ( +$DDa!c',a!b'%rg A are inc#")e) wi ( (e Aca)e&ic Acc%"n ing Acce!! Pr%gra&' 1"e! i%n! $2$ $2' $2) $2/ $21 $24 $25 $27 $28 $2$9 $2$$ $2$' $2$) $2$/ $2$1 $2$4 $2$5 $2$7 $2$8 $2'9 $2'$ $2'' $2') $2'/ $2'1 $2'4 $2'5 $2'7 $2'8 $2)9 $2)$ $2)' Learning E! ' i&e Objec ive@!A T%+ic @&in'A $ Function and primary focus of financial accounting 1 $ (fficient allocation of resources 1 $ Investment2credit decision 1 $ Investment2credit decision 1 $ #b6ective of financial accounting 1 ' :ash versus accrual accounting 1 ) +enerally accepted accounting principles 1 ) <oles of the S(: and FAS 1 1 <ole of the auditor 1 1 Sarbanes2#xley Act 1 / (conomic conse3uences of accounting standards 1 / FAS =s standard2setting process 1 4 ,urpose of the conceptual frame!ork 1 5 <elevance and faithful representation 1 5 :omponents of relevance and faithful representation 1 5 :ost effectiveness 1 5 Dateriality 1 5 Financial accounting elements 1 7 Assumptions underlying +AA, 1 7 +oing concern assumption 1 7 ,eriodicity assumption 1 8 road accounting principles 1 8 @istorical costI 6ustification 1 8 <evenue recognition criteria 1 8 Datching principle 1 8 Full2disclosure principle 1 8 Fair value hierarchy 1 8 Deasurement attributes 1 $9 <evenue;expense and asset;liability approaches 1 $$ :onceptual frame!ork under IF<S 1 $$ International standard setting 1 $$ Accounting convergence 1

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/rie, E:erci!e! $2$ $2' $2) $2/ $21 $24 E:erci!e! $2$ $2' $2) $2/ $21 $24 $25 $27 $28 $2$9 $2$$ $2$' $2$) $2$/ $2$1

Learning Objec ive@!A T%+ic ' Accrual accounting 5 Financial statement elements 5,7,8 asic assumptions and principles 5,7,8 asic assumptions and principles 5,7,8 asic assumptions and principles $$ IF<S organi0ations Learning Objec ive@!A ' ' ) ) ) 5 5 5 5 5,7,8 5,7,8 7,8 5,7,8 5,7,8 5,7,8

E! ' i&e @&in'A $1 1 $9 $9 $9 $9

E! ' i&e T%+ic @&in'A Accrual accounting '9 Accrual accounting $1 FAS codification research $1 FAS codification research '9 ,articipants in establishing +AA, $9 Financial statement elements $9 :onceptsI terminologyI conceptual frame!ork $9 Mualitative characteristics $1 asic assumptions, principles, and constraints $9 asic assumptions and principles $9 asic assumptions and principles $1 asic assumptions and principles $1 asic assumptions, principles, and constraints $1 asic assumptions, principles, and constraints $1 Dultiple choiceI concept statements, basic assumptions, principles $1

CPADCMA E:a& 1"e! i%n! :,A2$ :,A2' :,A2) :,A2/ :,A21 :,A24 :,A25 :,A27 :,A28 :,A2$9 :,A2$$ :DA2$ :DA2' :DA2) Ca!e!
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Learning Objec ive@!A 5 5 ) 5 5 5 $ 5 $$ $$ $$ ) 5 5 Learning Objec ive@!A

T%+ic Mualitative characteristics Mualitative characteristics Standard2setting Mualitative characteristics Mualitative characteristics Mualitative characteristics #b6ective of financial reporting Financial statement elements IF<S standard setting structure IF<S conceptual frame!ork :onvergence process Standard2setting Mualitative characteristics <ecognition concepts T%+ic

E! ' i&e @&in'A ) ) ) ) ) ) ) ) ) ) ) ) ) ) E! ' i&e @&in'A

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Audgment :ase $2$ <esearch :ase $2' <esearch :ase $2) <esearch :ase $2/ <esearch :ase $21 :ommunication :ase $24 :ommunication :ase $25 (thics :ase $27 Audgment :ase $28 Audgment :ase $2$9 Audgment :ase $2$$ Audgment :ase $2$' Analysis :ase $2$) Audgment :ase $2$/ <eal Norld :ase $2$1 Audgment :ase $2$4

Air France-9LM Ca!e

) ) / ), $$ ),/ 5 / 1 5 1,5 5 8 8 8 5,8 $$ $$

The development of accounting standards Accessing S(: information through the Internet Accessing FAS information through the Internet Accessing IAS information through the Internet Accounting standards in :hina <elevance and reliability Accounting standard setting The auditors= responsibility Mualitative characteristics +AA,I comparability and the role of the auditor :ost effectiveness The reali0ation principle The matching principle :apitali0e or expenseO (lementsI disclosuresI The +A, :onvergence Air France2Q"D2 Financial statements, accounting principles

)9 )1 /9 /9 49 )9 49 )9 '9 '9 )9 '9 '1 '9 '9 '9 )9

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